Withholding Tax on Total Return Swaps Owned by Foreign Persons – Recent IRS Director Directive and Proposed Legislation

Total return swaps have been in the news several times over the last few years. Recent legislative proposals in December 2009 and February 2010 and an IRS directive have intensified the focus on them. Tax issues and non-tax issues arise in many different types of swap situations including swaps based on publicly traded securities, private companies, automated swap program trading, master limited partnerships, basket swaps, and U.S. real property holding companies. Offshore funds need to consider the impact of these new developments in addition to other non-tax considerations when using total return swaps.

The IRS recently issued an industry director directive (“IDD”) regarding total return swaps. The IDD basically sets forth audit guidelines for IRS agents to use when auditing banks and their use of swaps. This directive may also be used as a guide by IRS agents auditing offshore hedge funds. The IDD discusses the IRS’s views regarding four different swap situations in terms of when U.S. withholding would be required in such situations (at the rate of 30%, or lower if a treaty is applicable), and what information to gather on audit in order to make such determinations. In addition, currently proposed legislation would subject more swaps to withholding.

Industry Director Directive
U.S. source dividend payments from U.S. withholding agents to foreign persons are generally subject to withholding tax obligations. The withholding tax rate is 30%, unless the payee is entitled to a lower rate under an income treaty with the U.S. Typically, offshore funds are not entitled to a lower rate under an income tax treaty with the U.S. However, payments under a notional principal contract, such as a swap, are generally sourced to the residence of the payee under a longstanding IRS regulation (Treas. Reg. Sec. 1.863-7). Therefore, the payments would not be subject to the withholding obligation because they would not be U.S. sourced.

These favorable source rules have encouraged the development of the swap market. Many taxpayers and withholding agents have taken the position that no withholding tax applies to swaps. Over the years, the IRS and others have questioned whether foreign persons should be able to avoid U.S. withholding tax by entering swaps, particularly total return swaps (“TRSs”). In 2009, the IRS identified TRSs entered into by foreign persons to avoid US withholding tax as a Tier I Issue, subjecting such transactions to heightened scrutiny. The objective of the IDD is to determine ownership of the underlying stock for federal income tax purposes and to provide guidance to IRS agents regarding what information to gather. The IDD recognizes the validity of the sourcing rule for swap payments under current regulations, but seeks to apply a “form over substance” agency analysis in certain scenarios. Due to withholding risks and the increased focus on TRSs, counterparties may be more reluctant to enter TRSs than they used to be.

Four Swap Situations in the IDD
The IDD provides guidance to IRS agents examining withholding tax obligations of U.S. financial institutions and provides information document requests (“IDRs”) for each situation. Agents can use IDRs to gather information and develop facts when requesting information. The IDD can also be used as a resource when auditing offshore hedge funds.

The IDD describes four representative situations and provides guidance as to how IRS agents should review each situation in determining whether a TRS should be recharacterized so that the foreign person is treated as the owner of the underlying stock for federal income tax purposes. The four situations have different levels of risk, and an IDR has been developed for each situation. The last one, the fully synthetic one where the foreign person never owns the stock, is the one with the least or no risk.

A. Cross In/Cross Out Transaction
Crossing in or crossing out means a transaction that is not executed in the market but instead is done privately by contract. In a “cross in/cross out” transaction, a foreign person (such as an offshore fund) sells U.S. publicly traded stock to a U.S. financial institution and simultaneously enters into a TRS that references the stock with the same financial institution (the “cross in”). Under the terms of the TRS, the foreign person pays an interest amount as well as any depreciation on the stock to the swap counterparty. The swap counterparty pays any appreciation on the stock as well as any dividend payment made on the stock to the foreign person. Upon the termination of the swap, the foreign person then repurchases the stock from the financial institution (the “cross out”). In a cross in/cross out transaction, the foreign person holds the swap over the record date of the dividend payment. To conclude the transaction, the swap is terminated, and the stock is repurchased from the financial institution.

When a transaction matches the general pattern described above, IRS agents are instructed by the IDD to review the transaction for several factors in order to determine whether the foreign person is deemed to have owned the stock for tax purposes and if withholding tax should have applied. The purpose of the inquiry is to determine whether the foreign person maintained beneficial ownership through an agency relationship, sale and repurchase agreement, securities lending relationship or otherwise.

The IDR evaluates factors such as pricing risk, voting rights, return of the same stock, requirements to hedge by owning the stock, etc.

B. Cross-in/Inter-dealer Broker (“IDB”) Out Transaction
In a “cross in/IDB out” transaction, the facts are the same as in the cross in/cross out transaction except that after the termination of the swap, the foreign person purchases the stock from a third party unaffiliated with the swap counterparty. In this situation, the IDD directs IRS agents to determine whether there was a pre-existing arrangement for the foreign person to repurchase the stock from the third party. One example of such an arrangement would be where an IDB agrees to purchase the stock from the swap counterparty and resell it to the foreign person.

In determining whether the swap should be recharacterized for tax purposes and subject to withholding tax, the IRS agent is instructed by the IDD to look for such factors as whether the counterparty received an unusually small commission in connection with any trades, whether the U.S. financial institution paid or received any fees to or from the unaffiliated third-party seller, and whether the foreign person and the counterparty entered into an arrangement with respect to the foreign person reacquiring the stock upon the termination of a TRS.

C. Cross-In/Foreign Affiliate Out Transaction
The facts of a cross-in/foreign affiliate out transaction are the same as a cross in/cross out transaction except that the foreign person enters into a TRS with a foreign affiliate of the U.S. financial institution as the swap counterparty. The foreign affiliate enters into a mirror swap with the U.S. financial institution to reduce its exposure to risk on the TRS.

The IDD directs IRS agents reviewing a cross-in/foreign affiliate out transaction to review both the U.S. financial institution and the foreign affiliate under the standards set forth for a cross-in/cross-out transaction. In addition, the IDD states that it may be possible for both the U.S. financial institution and the foreign affiliate to be treated as withholding agents with respect to the dividend payments.

D. Fully Synthetic
In a fully synthetic transaction, the foreign person does not own the stock prior to entering into the TRS and does not acquire the stock after the termination of the TRS.

The IDD states that generally a fully synthetic transaction should not require the counterparty to withhold on payments on the TRS unless certain facts indicate that the foreign person exercised control with respect to the counterparty’s hedge and, therefore, may have obtained beneficial ownership of the stock as a result of entering into a TRS. Some facts that may indicate “beneficial ownership” include when a foreign person holds a TRS position that is so large or so illiquid that a swap counterparty must acquire the underlying stock to hedge its position, transactions in which the U.S. financial institution hedged its position by retaining the stock on its books, and transactions in which the foreign person maintained or controlled voting rights with respect to the stock.

Proposed Legislation
Legislation has been proposed on several occasions that would subject swap payments that reference U.S. equities to the 30% withholding tax. For example, the Administration’s fiscal year 2011 revenue proposals, issued in February 2010, would treat income on equity swaps that reference dividends paid by a domestic corporation as U.S. source income. The Administration’s proposal would be effective for payments after December 31, 2010. Legislation proposed in December 2009 would initially only subject “dividend equivalents” to withholding tax on those equity swaps with certain criteria such as whether the foreign person transfers the underlying security, the financial institution transfers the underlying security to the foreign person, or the swap references nonpublicly traded securities. Such swaps would be subject to withholding 90 days after enactment of the legislation. Dividend equivalent payments on other equity swaps would be subject to tax two years after the date of enactment.

The recent audit guidelines in the IDD and proposed legislation highlight the increased focus on total return swaps and demonstrate the need for tax planning and tax risk evaluation for offshore funds and financial institutions that engage in such activities.